exitEvery founder of a growth startup dreams of a big, successful exit — a sale of the company for millions of dollars. But that dream could be shattered if the investors are able to cause the company to be sold prematurely with proceeds only equal to or barely exceeding the investors’ liquidation preferences, leaving little or nothing for the founders. Such a proposed deal will almost always be opposed by the founders, believing that the company could achieve a much higher valuation if it remained independent for a bit longer. Whether or not such a deal gets consummated over the objections of the founders depends on state law provisions and negotiated contractual terms that combined will determine the one factor that ultimately matters: control over the deal process.

Background: Liquidation Preference and Investment Horizon

In a typical round of venture funding, the investors receive a liquidation preference, i.e., the right to receive first dollars (after creditors are paid) up to an agreed amount in any sale of the company. In a company’s first institutional funding round (typically designated as Series A), a liquidation preference of 1X plus annual dividends of 8% is “market”, i.e., the investors get an amount off the top equal to the amount they invested plus accumulated dividends before the common shareholders receive anything. Later rounds (Series B, Series C, etc.) may have liquidation preferences of higher multiples of dollars invested, e.g., 1.5X, 2X, etc. A more investor friendly variation is what’s called participating preferred, in which the investors, after receiving their liquidation preference, then share pro rata in the remaining proceeds with the common shareholders, often up to some maximum amount.

So if a VC is not sanguine about a portfolio company’s long term prospects, he may be happy to sell the company for an amount equal to his liquidation preference, particularly at a point several years into the investment. In this regard, the time horizons of founders and institutional investors are inherently in conflict. A venture fund’s limited partnership agreement will typically limit the fund’s life tomoney vs. time ten years, with the initial three years designated for sourcing investments and the remaining seven for exits. With certain exceptions, a fund manager is required to distribute any profits to the fund’s limited partners by the expiration of that ten-year period, which is why a VC’s investment horizon in any given portfolio company is typically three to seven years. Consequently, a VC will often favor a quick exit because it offers a higher risk-adjusted return, and eliminates further risk to their investment. In other words, the VC might believe there’s some likelihood the company’s valuation may increase, but why risk it if he’s entitled to his liquidation preference, particularly if the wind-down of his fund is imminent? Free of such timing constraints, a founder on the other hand would almost always prefer to buy more time, particularly when the company’s projections show an upward trajectory. The founder’s problem, though, is that acquirors will generally value a company based primarily upon historical data, and will either ignore or heavily discount projected metrics.

State Law

So in a sale of the company proposed by the investors and opposed by the founders, who determines whether the deal gets consummated? The starting point is state law. The corporate statute of the state of the company’s incorporation will dictate the minimum vote threshold needed from shareholders. Some state statutes are more protective of common shareholders (founders almost always hold common shares) by requiring approval of the common holders voting separately as a class, essentially a group veto, and/or may require a supermajority vote, which gives the common the ability to block a deal if they collectively own enough shares to prevent the majority from meeting the vote threshold. States that are less protective of common shareholders will require only approval of a simple majority of holders of all shares outstanding, without requiring a separate class vote. That’s the Delaware model. New York voting rightscorporations organized before 1998 must secure a two-thirds majority of all holders unless their charter provides for a simple majority (simple majority for post-1998 corporations), and a separate class vote is required to approve a merger if the shareholders receive stock of the acquiror or another entity containing attributes not included in the target’s charter for which the target’s shareholders would have been required to approve in a separate class vote under New York law.

Another source of state law that impacts control over the deal process is case law regarding a director’s fiduciary duty. Before a proposed acquisition even gets to a shareholder vote, it must be approved first by a majority of the target company’s board, whose actions must be consistent with the directors’ fiduciary obligations. These include primarily the duty of care (generally, the obligation to be informed and diligent) and the duty of loyalty (essentially, the obligation to put the interests of the company and the shareholders above a director’s personal interests and not have any conflicts). Shareholders have a right to sue directors for breaches of fiduciary duty, and common shareholders will have a stronger or weaker case in attacking approval of the sale of a company as a violation of fiduciary duty depending on how favorable a particular state’s fiduciary duty case law is to the common holders. Delaware fiduciary duty case law is regarded as board friendly.

Contractual Terms

Some of the most important terms negotiated by VCs in a venture investment are the ones impacting control, both at the board level and the shareholder level. As mentioned above, a sale of the company must first be approved by a majority of the directors. The allocation of board seats is determined by negotiation during each round of funding. Although a fair outcome would be for investors to receive board representation in proportion to their share ownership (e.g., two of five seats when owning 40% of the outstanding shares), the investors will often negotiate for and receive disproportionate representation on the board and sometimes even a majority. A typical board composition arrangement might be a five-person board consisting of two directors designated by the investors, two directors selected by the common shareholders and one independent industry expert mutually selected by the common holders and the investors. But if the industry expert is someone with whom the investors have a preexisting relationship, human nature is such that he will view the investors as a source of future opportunities and tend to side with them, thus giving the investors an effective majority.

Other key control rights negotiated for by VCs are so-called protective provisions, which give the investors a veto over major decisions, including a sale of the company. Here, the battle is over what transactions or decisions make the list, and what vote threshold is required within the class of preferred. But a veto is only a right to block, not a right to approve. It doesn’t give the preferred the right to compel the company to consummate a deal opposed by the requisite holders. That’s where drag-along rights come into play.

Drag-along rights give investors the power to require other holders to vote in drag alongfavor of a deal the investors are proposing, sometimes conditioned on board approval. If a sufficient number of shares are so encumbered, the investors can ensure that holders of a requisite percentage of the outstanding shares or close enough to it vote to approve a deal favored by the investors.

So Who Controls the Deal Process?

Putting it all together, investors are more likely to control the deal process if all or at least some of the following are true: the company is incorporated in a state that does not require a class vote of the common to approve a sale of the company, the state has fiduciary duty case law favorable to directors, the investors have an actual or effective majority of the board and the investors control the cap table either outright or through a combination of ownership and drag along rights. In limited cases, the common shareholders will nevertheless be able to negotiate for a share of the proceeds in sub-liquidation preference deals, getting the preferred to relinquish some of the amount they’re otherwise contractually entitled to. Such an outcome is more likely to occur where the investors are able to approve a deal at the board level, but the common shareholders have one or more of the other factors in their favor, such as ownership of enough shares to block the vote or the benefit of common shareholder favorable fiduciary duty state case law. Or sometimes, the VCs just want to sweeten the pot to create the appearance of fairness to preserve a good reputation. But the VCs will rarely just give anything anyway; they’ll likely condition any common shareholder liquidation preference carveout on the recipients signing a release.

Earlier this year, Union Square Ventures Managing Partner Fred Wilson famously referred to corporate VCs as “The Devil”, when he asserted that companies should not be investing in other companies, that they should be buying other companies but not taking minority positions in them, that the “access” rationale for corporate venture is a reason why entrepreneurs should not want them in the room and that startups who take investment from them are “doing business with the devil”.  Ouch!  So why the hostility?

Corporate venture capital refers to venture style investments in emerging companies made by venture capital divisions of large companies, as distinguished from venture investments made by the more google Vtraditional investment funds that most people associate with venture capital. I’ve been seeing corporate VC term sheets with greater regularity lately, so I decided to blog about some of its characteristics, advantages and disadvantages relative to institutional venture capital.

Indeed, corporate VC appears to be on the rise. According to the National Venture Capital Association, corporate venture deployed over $7.5 billion in 905 deals to startups in 2015, a fifteen year high and representing 13% of all venture capital dollars invested for the year but 21% of all deals consummated.  From 2011 to 2015, the number of corporate VC divisions in the United States rose nearly 50% from 1,068 to 1,501   And according to CB Insights, the average corporate VC deal size has consistently been larger than the average institutional VC deal size over the last 14 quarters ended June 2016, with corporate VC deal sizes averaging above $20 million over the previous five quarters.

intel capitalBig technology and healthcare companies have long made venture style investments in startups. Google Ventures, Intel Capital, Dell Ventures and Cisco Investments are veteran corporate VCs that immediately come to mind. But it’s the relatively recent cisco investmentsarrival of new corporate investors that have driven the growth in corporate VC, in sectors ranging from transportation (e.g., GM’s $500 million investment in Lyft) to financial services to convenience stores.

Corporate VC programs have dramatically different overall objectives than institutional VC funds. Primary among these objectives is bolstering internal research and development activities and gaining access to new technologies that complement the corporation’s product development efforts. Venture investments are also a way for corporations to gain intelligence on disruptive products and salesforce vtechnologies that could pose a competitive threat.  A minority investment could also be the first step toward an eventual acquisition of the portfolio company.  More limited objectives might include establishing an OEM partner, a channel for additional company product sales or even a product integration that might drive sales for the investing company.  And yes, there’s also the objective of financial returns.

If a company is considering launching a venture capital program, it’s important to choose a structure that will align with its investment objectives. Corporate VC programs can either be structured internally, where a company invests from its own balance sheet, or externally.  Generally speaking, internal divisions are more comcast venturesappropriate for strategic investments intended to support a corporate sponsor’s core business.  One downside of internal structures is that they tend to be more bureaucratic and slower in decision making. Another is that the financial capacity to invest is basically a function of the corporate sponsor’s financial health, which could fluctuate over time.

External structures are more nimble in making decisions and generally have greater flexibility to make investments that may be disruptive to the investing company’s core business. Since investments are made microsoft venturesoff the corporate sponsor’s balance sheet, external structures allow companies to pursue riskier and more disruptive R&D. They also tend to attract more experienced investment managers and so are often better able to achieve both strategic as well as financial objectives.

In terms of exit strategy, corporate VCs seek a wider range of possible outcomes from an investment. Maximizing proceeds is typically not the exit strategy.  A corporate VC may just as likely view as a successful outcome the portfolio company becoming an acquisition target, an OEM partner, a channel for GE Venturesadditional company product sales or even a product integration that would drive sales for the investing company.  VC funds, on the other hand, seek one type of exit: a multiple return on their investment dollars from either an acquisition or a sale of shares following an IPO.

Advantages

As I mentioned above, investments by a corporate VC are funded by the corporation’s own balance sheet, and are thus not subject to the ongoing pressure from limited partners and the ten year time restrictions of a typical VC fund’s limited partnership agreement. The result is that corporate VCs are generally more patient and have longer time horizons than VC funds.

Corporate VCs generally negotiate for less control over their portfolio companies than do VC funds. This is largely because when the investor company is deemed to have the power to influence the operating or financial decisions of the company its investing in, the investor company is required to account for its investment under the equity method of accounting, under which the investor recognizes its share of the profits and losses of the investee. If the investor has 20% or more of the voting stock of the investee, the investor is presumed to have control.  Consequently, corporate VCs generally avoid taking 20% or more of a portfolio company’s voting shares.  The need to avoid indicia of control is also why corporate VCs often decline board representation.

Another advantage is that, as I mentioned above, an investment from a corporate VC may be the first step toward being acquired by that corporation, thus giving the portfolio company and its founders a clear exit pathway without having to go through a prolonged investment banking process. It can also create instant credibility in the industry, which can then be leveraged to attract talent and customers.  Finally, it can provide channel access, product integration and other benefits to help accelerate market penetration.

Disadvantages

Investment from a corporate VC may have certain disadvantages, however. First, a corporate VC’s strategic objectives may conflict with a portfolio company’s financial goals, which for example may motivate the corporate VC to block a proposed acquisition or subsequent investment if the transaction does not align with the strategic goals of the corporate VC’s parent. Second, corporate VCs often negotiate for a right of first refusal or option to acquire the company which would limit the company’s options going forward and have a chilling effect on other potential acquirers.  Third, it could antagonize potential customers or business partners who view themselves as competitors of the corporate VC. Fourth, corporate VC divisions often receive an annual allocation of dollars to invest, as opposed to an aggregate commitment of dollars that a fund receives to invest during the fund’s investment period, which means that the availability of follow-on funding may be tied to the financial capacity and whims of the parent company. And finally, a strategic may set the valuation higher than what the market will bear, which could make it difficult for the company to secure co-investors, which in turn could leave the company under-funded and, as mentioned just above, could leave the company vulnerable if the corporate VC parent isn’t able or interested in making follow-on investments.

Final Thought

So back to Fred Wilson’s choice words for corporate VCs.  Perhaps the root of the antagonism is the tendency for corporate VCs to drive up valuations, which makes deals more expensive for institutional funds and may crowd them out of certain deals entirely.  Wilson sort of implied as much when he stated in the same interview that a startup would only do a deal with a corporate VC if it couldn’t secure funding elsewhere or if the corporate VC was paying a higher price than he would pay.

In Part I of this two part series on model structures for seed rounds, I explained how the dramatic decline in the cost of launching an internet-based startup over the last 15 years primarily due to the disruptive effects of open source software and cloud computing has led to a surge in seed stage investing by angels and early stage VCs.  In Part I, I addressed seed rounds structured as equity, the two most common forms of which involve the issuance of modified versions of preferred stock designated as Series AA or Series Seed.

As I explained in Part I of this Series, the more complex, time consuming and expensive to negotiate deal documentation associated with Series A and later rounds can be justified when a company is raising several millions of dollars, but makes little sense for a seed round of a few hundred thousand dollars. The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents.  This Part II of the Series will address seed round structures fashioned as convertible notes or alternative instruments that functionally resemble convertible notes.

Convertible Notes

Convertible Notes advance the objective of deal document simplification and cost effectiveness even more than Series Seed and Series AA structures because they allow parties to defer negotiation of the thorniest issues to a next significant equity round.

Technically, convertible notes provide for payment of principal and interest on a maturity date of typically one to two years, but in reality these notes are not expected to be repaid.  Instead, the principal and interest is intended to get converted into the security issued in a next equity round meeting some minimum dollar amount, albeit typically at a discount to the next round’s pricing in an effort to reward the seed investors for the additional risk they’re assuming by investing at a more vulnerable juncture for the company.   In recent years, it has also become common for the valuation at which the seed investment is converted to be capped, in which case  the conversion price would be the lower of the discounted rate or the price based on the capped valuation.  Less sophisticated angels will focus on the interest rate and try to negotiate that higher; those more experienced in startup investing will understand that the conversion terms will have a far more significant impact on the value of their investment and thus focus on discount and cap.

Another way the practical reality departs from the technical is that if a qualified funding has not occurred and the note is not converted prior to maturity, the note is rarely paid at that point. Instead, a difficult conversation takes place between the company and the seed investor in which the company seeks to extend the maturity date.  The price for any such extension is usually in the form of more generous conversion terms for the investor.

Simple Agreement for Future Equity or “SAFE”

In 2013, the legendary accelerator Y Combinator introduced an alternative to theY Combinator convertible note which it called a Simple Agreement for Future Equity or “SAFE”. Although it looks like a convertible note in that it converts the investment amount into the next round’s security and typically features discounts and caps, it is not a promissory note for the simple reason that, unlike a note, there is no basic promise to repay the invested amount.  Essentially, a SAFE is a contract that provides for the type and amount of shares that will be issued in a qualified next round, if there is such a round, along with an option to receive either common stock or a return of the invested amount if the company is acquired prior to a qualified round.

The absence of a payment on maturity date feature is a major advantage to companies and a serious drawback for seed investors relative to convertible notes in that it removes an important source of leverage that the investor would otherwise have as a convertible noteholder if the company has been unable to raise a qualified next round before maturity. If that were to happen in the context of a convertible note, the note holder could demand payment and force the company into dissolution or bankruptcy.  That leverage would allow the investor to negotiate for an increase in the conversion discount or decrease in the cap.

The lack of a maturity date means that the SAFE is really only appropriate for a technology based startup that could scale quickly and achieve rapid growth. Conversely, a non-technology based startup could theoretically prosper and enrich its shareholders without the SAFE holder receiving anything for a long time, if ever.  In other words, a company may be able to grow organically without the need to do another significant raise, and may even be able to dividend out cash to its stockholders (not shared by the SAFE holders because they’re not yet stockholders), and the SAFE holders would not receive anything until the company gets acquired, if ever.

Keep it Simple Security or KISS

The Keep it Simple Security or KISS was created by another accelerator, 500 500 startupsStartups, in 2014, in reaction to resistance to SAFEs because of their lack of investor protections. KISSes more closely resemble traditional convertible notes, i.e., promise to pay on a maturity date, etc., and contain certain other important investor protections such as an option at maturity to convert into a newly created Series Seed (see my discussion of Series Seed in Part I of this two-part series), information rights and the right to participate in future funding rounds.  But inasmuch as the impetus for convertible note alternatives was a desire for simplification, cost effectiveness and time saving, it’s unclear whether the KISS, which actually contains a few more deal points to negotiate than convertible notes, will gain significant traction among seed stage companies and investors.

The cost of launching an Internet-based startup has fallen dramatically over the last 15 years. This democratization of internet-based entrepreneurship resulted primarily from two innovations: open source software and cloud computing. During the dot-com era, Internet-based startups had to build serversinfrastructure by acquiring expensive servers and software licenses and hiring IT support staff. So the first outside round of investment in an Internet-based startup was typically a Series A round of $3 million or more from one or more VCs. With the emergence of open-source software, however, startups for the most part were no longer forced to acquire software packages bundled with hardware. Another issue, though, was that startups had to acquire and maintain bandwidth to accommodate peak loads, resulting in expensive underutilization. But this all changed with the advent of cloud computing, which enabled entrepreneurs to launch an Internet startup with minimal upfront IT costs and to pay only for used bandwidth. In real dollars, the cost of starting up has declined from a few million dollars to a few hundred thousand dollars.

With the precipitous drop in the cost of launching an Internet-based startup came a significant rise in interest in seed investing by angels and early stage VCs. But the typical Series A document package (amended and restated certificate of incorporation, stock purchase agreement, voting agreement, cloudinvestor rights agreement, right of first refusal and co-sale agreement) is complex, time consuming and expensive to negotiate, and contains several economic, management and exit provisions that don’t become relevant until much later (e.g., if and when the company goes public). This level of complexity can be justified when a company is raising several million dollars, but not so for a seed round of a few hundred thousand.

The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents. Seed rounds are either structured as a simplified version of a priced Series A preferred stock or as debt that converts into the security issued in a next round of equity, typically at a discount. This Part I of a two part blog series on seed round investing will focus on priced equity structures; Part II will address convertible debt.

There are currently two alternative open sourced sets of equity seed round deal documents to choose from, each with the common goals of term simplification, cost reduction, transaction time compression and document standardization. Both feature terms similar to those found in a typical Series A deal, but stripped down from the robust set of economic, voting and exit rights usually contained in a Series A. The two deal document products are:

Series AA: Created by Cooley cooleyfor accelerator Techstarstechstarsfenwick
Series Seed: Created by Fenwick & West

The main terms of Series AA and Series Seed are as follows:

1X Non-Participating Preferred: Both Series Seed and Series AA feature 1X non-participating preferred stock, meaning on a sale of the company the investor must choose between his liquidation preference of 1X (i.e., one times his investment amount) or the proceeds he would receive on an as converted basis, but not both. In other words, the investor calculates which would yield the bigger payout and choose that one. On the other hand, participating preferred would give the investor two bites of the apple: first his liquidation preference, and then his share of remaining proceeds as a common shareholder on an as converted basis.

Antidilution Protection: Series Seed provides no antidilution protection. Series AA, however, has broad based weighted average antidilution protection. Most notably, antidilution protects the investor from the economic dilution resulting from down rounds. Weighted average is the type of protection that is more fair in that it factors in the dilutive effect of the actual down round (i.e., the conversion price doesn’t adjust all the way down to the lower down round price but rather takes into consideration the number of additional shares issued at the lower price relative to the number of shares outstanding), and broad based requires inclusion in the number of shares outstanding all outstanding options and options reserved for issuance (as opposed to narrow based which would not include options).

Board Composition: Both Series AA and Series Seed provide for boards consisting of 2 common and one preferred, except that Series AA conditions the preferred board member on the Series AA shares constituting at least 5% of the outstanding equity on a fully diluted basis.

Protective Provisions: These are veto rights in favor of the preferred. Series AA gives vetos over only changes to the Series AA. Series Seed includes vetos over changes in the Series AA, but also includes vetos over mergers, increasing or decreasing authorized shares of any class or series, authorizing any new class or series senior to or on a parity with any series of preferred, stock redemption, dividends, number of directors and liquidation/dissolution.

Right of First Offer on New Financings: Both Series Seed and Series AA give investors the right to purchase their pro rata share of new issuances.

Right of First Refusal: Series Seed gives investors a right of first refusal on shares held by key holders. Series AA does not.

Drag Along Rights: Series Seed gives Series Seed holders and founders the right to require common holders to include their shares or vote for any transaction approved by the board, by a majority of the common and by a majority of the Series Seed. No drag along in the Series AA.

So what standard Series A terms are missing from Series Seed and Series AA? Missing are dividend preference (not a big deal here inasmuch as the overwhelming majority of startups will not pay out dividends), registration rights and tag-along rights (also not a big deal inasmuch as founders rarely have an opportunity to sell their shares).

Overall, Series Seed and Series AA are worthy efforts to simplify terms and reduce transaction costs. There will certainly be situations, however, where investors will resist the weaker investor protections such as the absence of participating preferred and anti-dilution protection and stripped down protective provisions. Any effort to negotiate some terms back in will undercut the objective of diversification and simplicity.

SEC logoAt an open meeting on October 30, 2015, the Securities and Exchange Commission by a three-to-one vote adopted final rules for equity crowdfunding under Section 4(a)(6) of the Securities Act of 1933, as mandated by Title III of the Jumpstart Our Business Startups Act.   The final rules and forms are effective 180 days after publication in the Federal Register.

Crowdfunding is an evolving method of raising funds online from a large number of people without regard to investor qualification and with each contributing relatively small amounts.[i]   Until now, public crowdfunding has not involved the offer of a share in any Crowdfunding1financial returns or profits that the fundraiser may expect to generate from business activities financed through crowdfunding. Such a profit or revenue-sharing model – sometimes referred to as the “equity model” of crowdfunding – could trigger the application of the federal securities laws because it likely would involve the offer and sale of a security to the public.  Equity crowdfunding has the potential to dramatically alter the landscape of capital markets for startup companies. It has also been the subject of a contentious debate ever since it was included in the JOBS Act, pitting those who want to allow startups to leverage the internet to reach investors and to permit ordinary people to invest small amounts in them against those that view crowdfunding as a recipe for a fraud disaster.

The SEC had issued proposed rules in October 2013 (see my blog post here), and received hundreds of comment letters in response. When the final rules become effective (early May 2016), issuers for the first time will be able to use the internet to offer and sell securities to the public without registration.  Here’s a brief summary of the new crowdfunding exemption rules and where they deviate from the original proposal.

Issuer and Investor Caps

  • Issuers may raise a maximum aggregate amount of $1 million through crowdfunding offerings in any 12-month period.
  • Individual investors, in any 12-month period, may invest in the aggregate across all crowdfunding offerings up to:
    • The greater of $2,000 or 5% of the lesser of annual income or net worth, if either annual income or net worth is less than $100,000, or
    • 10% of the lesser of their annual income or net worth if both their annual income and net worth are equal to or more than $100,000.
  • Aggregate amount an investor may invest in all crowdfunding offerings may not exceed $100,000 in any 12-month period.

Many commenters believed that the proposed $1 million offering limit was too low, but the SEC in the end believed the $1 million cap is consistent with the JOBS Act. The SEC did state in the final rules release, however, that Regulation Crowdfunding is a novel method of raising capital and that it’s concerned about raising the offering limit of the exemption at the outset of the adoption of final rules, suggesting that it would be open to doing so down the road.

As for the individual investment limit, the final rules deviate from the original proposal by clarifying that the limit reflects the aggregate amount an investor may invest in all crowdfunded offerings in a 12-month period across all issuers, and also specifies a “lesser of” approach to the income test.

Financial Disclosure

Financial disclosure requirements are based on the amount offered and sold in reliance on Section 4(a)(6) within the preceding 12-month period, as follows:

  • For issuers offering $100,000 or less: disclosure of total income, taxable income and total tax as reflected in the federal income tax returns certified by the principal executive officer, and financial statements certified by the principal executive officer; but if independently reviewed or audited financial statements are available, must provide those financials instead.
  • Issuers offering more than $100,000 but not more than $500,000: financial statements reviewed by independent public accountant, unless otherwise available.
  • Issuers offering more than $500,000:
    • For issuers offering more than $500,000 but not more than $1 million of securities in reliance on Regulation Crowdfunding for the first time: financial statements reviewed by independent public accountant, unless otherwise available.
    • For issuers that have previously sold securities in reliance on Regulation Crowdfunding: financial statements audited by independent public accountant.

The financial disclosure requirements contain a number of changes from the proposal that hopefully will help reduce the costs and risks associated with preparing the required financials. Instead of mandating that issuers offering $100,000 or less provide copies of their federal income tax returns as proposed, the final rules require an issuer only to disclose total income, taxable income and total tax, or the equivalent line items, from filed federal income tax returns, and to have the principal executive officer certify that those amounts reflect accurately the information in the returns.  This minimizes the risk of disclosure of private information which would exist if tax returns had to be provided.  In addition, reducing the requirement for first time issuers of between $500,000 and $1 million from audited financials (as had been proposed) to reviewed financials is a sensible accommodation inasmuch as the concern about the cost and burden of the audit relative to the size of the offering is even greater for first timers who would need to incur the audit expense before having proceeds from the offering.

Intermediaries

  • Offerings must be conducted exclusively through one platform operated by a registered broker or funding portal.
  • Intermediaries required to provide investors with educational materials, take measures to reduce the risk of fraud, make available information about the issuer and the offering and provide communication channels to permit discussions about offerings on the platform.
  • Funding portals prohibited from offering investment advice, soliciting sales or offers to buy, paying success fees and handling investor funds or securities.
  • Funding portals must register with the SEC by filing new Form Funding Portal, which will be effective January 29, 2016.

The rationale behind the requirement to use only one intermediary is that it helps foster the creation of a “crowd”. Having one meeting place enables a crowd to share information effectively, and minimizes the chances of dilution or dispersement of the crowd. This in turn supports one of the main justifications for equity crowdfunding, which is that having hundreds or thousands of investors sharing information increases the chances that any fraud will be exposed, thus the “wisdom of the crowd”. The one platform requirement also helps to minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding. For example, allowing an issuer to conduct an offering using more than one platform would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit.

One important deviation from the proposed rules is that funding portals will be permitted to curate offerings based on subjective criteria, not just based on perceptions of fraud risk.  A second important deviation is that all intermediaries will be allowed to receive as compensation a financial interest in the issuers conducting offerings on their platforms, which will expand the options available to cash-starved startups.

Preliminary Thoughts

The ink is still wet on the SEC’s 686 page release, but here are some preliminary thoughts. Equity crowdfunding has the potential to create new capital raising opportunities for many startups and early stage companies by removing antiquated regulatory barriers and allowing companies to leverage the internet and social media to reach and sell to prospective investors without regard to accredited investor status. The federal securities laws were written over 80 years ago when investors had no access to information about issuers.  In the internet age, prospective investors have many sources of information at their fingertips and the “wisdom of the crowd” can both steer dollars to the most promising companies and ensure that ample information is spread to interested parties.

As I’ve stated before, however, the SEC’s preoccupation with investor crowdprotection has created a disconnect between the potential of equity crowdfunding and its reality, now expressed in the final rules. To be fair, the framework for most of the rules was predetermined by what Congress enacted in Title III of the JOBS Act and the final rules do contain some welcome relief from the original proposal. Nevertheless, I fear that the burden and expense associated with some of the rules will make Regulation Crowdfunding far less attractive to most companies than traditional offerings under Rule 506 notwithstanding the latter’s pro-accredited investor bias. For example, the requirement to produce audited financial statements for offerings above $500,000 (except for first time Regulation Crowdfunding issuers) will seem prohibitively expensive when compared with accredited investor-only Rule 506 offerings where no financials are mandated at all. It’s also unclear how the burdensome rules governing intermediaries will attract established investment banks, or even boutiques, and will likely leave the field open primarily to persons with scant resources and experience. Lastly, even in the context of a successful crowdfunded offering, companies will also need to consider carefully the negative consequences associated with a shareholder base consisting of potentially thousands of individual investors. Those consequences include the expense associated with keeping them informed, the difficulties of securing quorums and votes and the inevitable misgivings VCs will have of investing in a crowdfunded startup.

In the final analysis, though, Title III equity crowdfunding will finally become law, meaning that issuers will for the first time be allowed to leverage the internet to sell securities to an unlimited number of investors without registration and without regard to accredited investor status, and that is decidedly a treat.

[1] The term “crowdfunding” has also been used more broadly as a somewhat generic term for any campaign to raise funds through an online platform.  These include non-equity crowdfunding (i.e., rewards or pre-order based), “accredited” crowdfunding (in reliance on Rule 506(b) or 506(c)) and registered crowdfunding (in reliance on Regulation A+).  This post will use the term only as it applies to small equity offerings to many investors, each contributing relatively small amounts, and soon to be available under Regulation Crowdfunding.

It’s never easy to take an entire business day out of the office, but the annual Cornell Entrepreneurship Summit is well worth it.  The 2014 edition, dubbed “Beyond the Horizon”, was no exception.  One thing that struck me about this year’s summit was that, unlike previous years, none of the entrepreneur speakers were Cornell alums, demonstrating that the summit has evolved from a Cornell entrepreneurship event to a Cornell event about entrepreneurship.  As to the speakers, here are some of the more memorable and meaningful takeaways for me.

Skybox CEO Tom Ingersoll
How did a startup succeed in creating a real-time Google-Earth?  Skybox Imaging CEO Tom Ingersoll asked the audience, “Have you looked at your house on Google Earth? Disappointed it was two years old?” Because satellites are so expensive to build and launch, most of the pictures that we see are of poor quality and years out of date. Until now. Skybox knew that real-time satellite imaging would require dozens of satellites, a prohibitively expensive endeavor with the cost of a single satellite being around $850 million.  So Skybox needed to find a way to build satellites for a fraction of that, and created a lightweight, nimble satellite in-house for about $10 million.  Ingersoll insisted that the key to Skybox’s success is in execution, and evoked the line mostly attributed to Thomas Edison (also a favorite of Steve Jobs):  “Vision without execution is hallucination”.  Ingersoll said that another key to Skybox’s success is that it has had a patient board of directors, which enabled Skybox to say “no” to Google twice, before finally agreeing to be acquired earlier this year.

If a company offered its employees unlimited vacation time, would anyone show up to work?  Return Path CEO Matt Blumberg revealed that when his company instituted that policy it experienced no higher vacation rates.   The author of “Start-Up CEO” said that his employees are encouraged to take as much time off as they can while maintaining high performance and achieving milestones.  “We don’t count the hours they work, so why should we count the hours they don’t?”

Sols CEO Kegan Schouwenburg

“We went from the cobbler to standardized mass manufacturing and now today we are going to change all that with digital manufacturing”, announced Kegan Schouwenburg, CEO of Sols Systems.  Sols captures a 3-D model of a patient’s foot, makes therapeutic adjustments in a web-based app and manufactures a final product with a 3-D printer.  Schouwenburg also demonstrated the direct to consumer version of the service where a customer can scan his or her own foot with a smartphone and order a custom fit insert.  “One super cool thing about digital manufacturing: no waste”, Schouwenburg said.

Despite recent mega-exits like WhatsApp, Tumblr and Waze, billion-dollar exits are rare, so much so that they’ve been designated the name of a mythical creature, a unicorn.  Every VC chases them.  “Birthing a unicorn is hard”, proclaimed CB Insights CEO Anand Sanwal.  Sanwal’s data shows that only one percent of exits are unicorns, while 72% are below $200 million.  Sanwal said that we may not be in a bubble yet, but valuations are “frothy”.  Although billion dollar valuations require lots of capital raising, some of the recent unicorns raised money late at higher valuations, or never, including Shutterstock and former Cornell Entrepreneurship Summit presenter Wayfair, and Anand said that “these are the companies we should celebrate”.

Your company is invited by a local meetup group to present at demo day with other startups, and you accept.  The group announces the demo day lineup of startups in an e-blast, on its website, on its Facebook page and through banner ads on a tech e-zine.  On demo day, the room is packed and you nail your presentation.  The following month, you close on an investment with a few angels who attended your demo day presentation.  Have you just violated the securities laws?

For years, startups and emerging companies have been presenting at capital raising forums organized by accelerators, meetup groups, professional organizations and other similar groups and securing funding from investors they met at such events. But it has never been clear to securities lawyers how issuers could do so without violating the ban on general solicitation in private offerings.

Historically, startups and emerging companies looking to raise capital in the private markets have relied overwhelmingly on Rule 506 of Regulation D, primarily because there is no limit on the amount that may be raised and because the shares offered and sold are deemed “covered securities” and thus exempt from the most onerous requirements under state securities laws.  The ban on general solicitation in Reg D offerings is contained in Rule 502 of Reg D, which states explicitly that:

“[N]either the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

  • Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
  • Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising”

Despite the popularity of Rule 506 offerings, growing criticism of the Rule’s prohibition on general solicitation as an antiquated and overly burdensome impediment to capital raising led to the passage in 2012 of the JOBS Act, which in part called on the SEC to promulgate final rules that would lift the general solicitation ban (among other reforms).  In September 2013, the SEC issued final rules on a new exemption under Rule 506(c) that permits general solicitation so long as certain additional requirements are met, but also left intact as new Rule 506(b) the traditional private offering exemption with no general solicitation (but without the additional requirements).  See my post on the general solicitation rules here.

Accordingly, companies making private offerings of securities under Rule 506 now have two alternatives:

  • Offerings without general solicitation: May sell to up to 35 non-accredited investors and to an unlimited number of accredited investors, with accredited investors being allowed to self-verify (generally by filling out a standard questionnaire).
  • Offerings with general solicitation:  All purchasers must be accredited investors, and the company must use reasonable methods to verify status.  The Rule includes a non-exclusive, non-mandatory list of documents that a company could review to verify accredited investor status.  These include tax returns, bank statements, brokerage statements and credit reports.  The Rule also allows a company to rely on a written statement provided by a lawyer, CPA, investment advisor or broker dealer.

Now that they have a choice, companies will need to consider carefully which route to take.  General solicitation clearly allows the company to reach a far greater audience.  But there are drawbacks.  The additional accredited investor verification requirements could turn off potential investors because of the intrusiveness associated with having to present tax returns or brokerage statements.  There are increased transaction costs (primarily higher lawyers’ fees) and a slowdown in the deal process.  The additional burdens will get even worse if proposed SEC rules are adopted, which would require companies using general solicitation to file a Form D in advance (currently it must be filed within 15 days following the first sale) and include solicitation materials in the filing.

As mentioned above, it is unclear on what basis companies were able to present at demo day events before September 2013 without violating the general solicitation ban.  The SEC may have chosen to look the other way because the events contribute to economic growth and are typically managed by credible organizers, and thus there has not been any urgency for anti-fraud enforcement.   But it stands to reason that now that there is a legitimate path to general solicitation private offerings, albeit with additional requirements, the SEC may begin scrutinizing demo day events more closely to ensure that those additional requirements are satisfied.  Companies may find themselves on the wrong side of an SEC investigation if:

  • they actually sell shares or their presentation is deemed to be an “offer” of securities;
  • the demo day event is deemed to be a form of general solicitation; and
  • not all purchasers are accredited or the company failed to use reasonable verification methods.

So whether or not a demo day presentation could result in securities exposure will depend on the content of the presentation and the manner in which the event is promoted.

The securities laws define the term “offer” fairly broadly to include every attempt or offer to sell a security for value.  Referring in a presentation to the terms of an ongoing offering, to an offering generally or even to the need and/or desire to raise capital would likely be deemed to be an offer to sell securities, even though under the contract laws of most states it would probably be construed as simply an invitation to make an offer or to begin negotiations.  The SEC has long held that statements are deemed to be “offers” if  they may have the effect of conditioning the market or arousing public interest in an issuer or its securities.

Assuming the presentation is an “offer”, the next question is whether it involved general solicitation.  Demo day organizers typically promote such events on their public website, in print, online or broadcast media and in postings to their social media accounts.  Determining whether or not a communication is a general solicitation requires a facts and circumstances inquiry.  Announcing the event on a medium that is accessible to everyone, such as an unrestricted website or a print or online newspaper, is per se general solicitation under Rule 502(c) (see above).  As to social media, even though the universe of people with access to a social media account may be much more limited than an unrestricted website, there is always the danger that a posting on Facebook or tweet on Twitter could be freely forwarded, and therefore in all likelihood would be considered general solicitation.

As mentioned above, there are solid reasons why companies would choose to structure an offering as one without general solicitation under Rule 506(b).  Doing so would avoid the extra compliance hassle and cost associated with a 506(c) offering (with general solicitation), as well as the difficulty of securing from purchasers the bank or brokerage statements or tax returns, or a third party certification, needed to verify status.

In conclusion, the following could be used as rules of thumb when considering an invitation to present at an event:

  • If the demo day is promoted on an open access website, through any print, online or broadcast media or in postings to social media accounts, the presenting company should either refrain from making any references to capital raising (i.e., limit the presentation to its products and services) or treat the effort as a Rule 506(c) offering by limiting sales of securities to accredited investors and obtaining copies of tax returns, or bank or brokerage statements.
  •  If the demo day is by invitation-only, or promoted through a password-protected website, and directed solely to persons with whom the organizers or the company have a financially substantive preexisting relationship, the company should be free to speak about its securities offering or capital raising needs generally and treat the effort as a Rule 506(b) offering.

In Part I of this two-part series, I explained how a favorable pre-money valuation can be undercut by a large option pool baked into the pre-money cap table.  In this Part II of the series, I will concentrate on one other deal term that can serve to undermine a negotiated valuation:  liquidation preferences.  Failure to focus sufficiently on liquidation preference mechanics could also lead to a distortion of incentives and serious strategic issues down the road.

First, a simple scenario.  You’re a startup founder negotiating a $5 million Series A round with a VC and you agree on what seems like a generous pre-money valuation of $10 million.  The company issues the VC preferred shares constituting one-third of the overall equity of the company ($5 million/$15 million post money).  The company grows nicely over the next seven years and receives an acquisition offer of $30 million.  You can hardly believe your good fortune as you quickly calculate that you, your co-founders and angel investors will collectively reap $20 million (2/3 of $30 million).  But your lawyer takes a look at your charter and delivers the bad news: the common holders’ share of the proceeds is actually only $11 million.  What happened?    

In most VC deals, the investors receive shares of preferred stock in exchange for their investment.  Although this form of security is usually associated with a whole range of economic, management and exit rights superior to common stock, the name preferred derives from one of the most important of these rights, namely the liquidation preference.  In its simplest form, the “liq pref” (as VCs often refer to it) is the investor’s right on a sale of the company to receive a certain amount of the proceeds off the top before the common holders receive anything.  In the real world, however, liquidation preference provisions are more complicated, so I’ll describe the typical variations and how they could end up impacting the acquisition proceeds waterfall in spite of the negotiated pre-money valuation.

The amount of the initial preference is usually not less than the amount invested, and is often a multiple of that amount, e.g., 1.5x, 2x, etc.  It’s also not uncommon for accrued but unpaid dividends to be added to the initial amount.  What happens next depends on whether the preference is participating or non-participating.  With participating preferred, the investor first receives the agreed-upon initial amount before the common holders receive anything, and then shares the balance of the proceeds (if any) pro-rata with the common on an as-converted basis.  With non-participating preferred, the investor does not share with the common after his initial preference amount.  But remember, preferred almost always has a conversion feature allowing a preferred holder to forego his preference and convert to common.  So with non-participating preferred, the holder has a choice to make, depending on what yields the most proceeds for him: either the preference amount, or his pro rata share on conversion.  With participating preferred, the holder generally does not have to make that choice; he gets the initial preference, and then he gets his pro rata share of the balance on an as-converted basis (but see below regarding capped participation).

In the above hypothetical Series A deal, the VC agreed to a $10 million pre-money valuation, thus receiving 1/3 of the overall equity, but also negotiated for and received a fully participating 2x liquidation preference with annual 10% cumulative dividends (payable on a sale).  The math works as follows:

 

Initial Preference                                             $13,500,000

            2 x $5,000,000            $10,000,000

            10% x 7 yrs.                $  3,500,000

 1/3 Participation                                               $ 5,500,000

            1/3 x $16,500,000       $  5,500,000

 Proceeds to Preferred                                       $19,000,000

 Proceeds to Common                                       $11,000,000

Companies will often try to limit the sting of the “double-dip” participation feature by negotiating a cap on the participation that follows the initial preference.  The cap is expressed in terms of a multiple of the investment amount, usually in the range of 2x to 3x, and the cap almost always includes the initial preference amount.  This is called capped participation, and participating preferred with no cap is referred to as full participating preferred. 

On the surface, both non-participating and capped participation seem better for the founders, but in practice both could lead to a distortion of incentives for the preferred and unintended consequences for everyone.  With full participation, the interests of the common and preferred will always be aligned; both classes will always be incentivized to seek the highest purchase price.  But with both non-participating and capped participation, there could be a range of prices in which the preferred have no incentive to seek a marginally higher price because within that range the common receive 100% of the marginal increase in price and the preferred receive no additional consideration. 

The two examples below illustrate this point.  Both examples assume a 1x liquidation preference on a $10 million investment, and a $10 million pre-money valuation where the investor is issued 50% of the equity.

EXAMPLE ONE: NON-PARTICIPATING

Acquisition Price

Proceeds to Preferred

Proceeds to Common

$10,000,000

$10,000,000

$0

$15,000,000

$10,000,000

$5,000,000

$20,000,000

$10,000,000

$10,000,000

EXAMPLE TWO: PARTICIPATION CAPPED AT 1.5X

Acquisition Price

Proceeds to Preferred

Proceeds to Common

$10,000,000

$10,000,000

$0

$15,000,000

$12,500,000

$2,500,000

$20,000,000

$15,000,000

$5,000,000

$30,000,000

$15,000,000

$15,000,000

 

Because neither of the above examples is fully-participating, the investor at some point will elect to convert to common and forego the liquidation preference, in each case at the point at which the purchase price is high enough so that the investor receives a higher pro-rata share on an as-converted basis than he’ll receive without conversion.  But notice that in each case there’s a range of purchase prices at which the investor stops receiving additional proceeds on the liquidation preference (on the lower end of this range) and before it makes economic sense for the investor to convert (at just above the upper end of the range).  In the first example, because there is no participation, the investor receives no additional proceeds between a $10 million and a $20 million purchase price (just above the latter being the point at which the investor would convert and take his 50% share).  So assuming the VC is looking to exit and the company receives an offer of $10 million, the investor would have no incentive to seek a higher price unless he believed the price could exceed $20 million.  Similarly, in the second example with a 1.5x participation cap, the investor would have no incentive to seek a price higher than $20 million (at which point he’s capped out at $15 million), unless he believes a $30 million price is achievable currently (above which he’d convert to common and surpass $15 million in proceeds). 

The foregoing phenomenon has been referred to by commentators as the dead zone or the zone of indifference.  I’ll call it the “range of indifference” just to be different.  Once the VC is in the range of indifference, he has no incentive either to negotiate for a higher price, or to defer a sale altogether to build more value in the company.  Even if the investor believed the Company may be worth 50% more in two years, he would have no incentive to take that risk because he’d receive no additional proceeds from the higher price.  The common holders, of course, would have the exact opposite set of incentives and would seek either to negotiate for a higher price or to continue to build value in the company in the hope of selling for a higher price down the road.  This distortion of incentives resulting from the range of indifference actually gets even more complicated as the company completes additional rounds of funding and particularly when an investor in a later round such as a Series D has priority over earlier rounds of preferred.

In any seed or early stage round negotiation between a company and a VC, one of the first and most contentious issues to be negotiated is valuation.  A company’s pre-money valuation will determine how much equity will need to be issued to the investor for any given amount of investment, and thus on its face would appear to be the most critical term in any term sheet.  But as I will show in this two-part series, a favorable pre-money valuation can be undercut by a large option pool baked into the pre-money shares outstanding and/or by a generous liquidation preference.  In this Part I of the series, I will concentrate on the option pool.

VCs almost always insist on a pool of options to be set aside for grants to key employees, both to recruit new talent and to retain existing talent. Startups and emerging companies are typically cash poor and thus have no choice but to use stock as compensation currency.  Options (or restricted stock) also serve to incentivize the management team with the chance to ride the upside potential of the company.  The existence of an option pool in and of itself is not controversial; the way it’s structured can be – if founders are paying attention.

Option pools are typically expressed as a percentage of the post-money shares outstanding on a fully-diluted basis, usually in the range of 10% – 20%.  So if the post-money number of fully-diluted shares (i.e., outstanding shares plus all shares that are subject to options and other rights to acquire shares) before adding the option pool is one million, a 10% option pool would consist of approximately 112,500 shares (112,500/1,112,500 = 10%).  So far so good.

Where the option pool gets interesting is in its impact on price per share of the VC’s investment, which in turn dictates the number of shares and the percentage of total equity to be issued to the investor.  Price per share is calculated by dividing the pre-money valuation by the pre-money number of shares outstanding, typically on a fully-diluted basis.  The issue then is what constitutes “fully-diluted”, i.e., which rights to acquire shares are included in calculating the total number of “fully-diluted” shares.  Should the options to be included in total shares be limited only to those that are outstanding (in other words, those that have been granted but not yet exercised), or should it be viewed more broadly to include options that have been authorized but not yet granted as in the option pool to be agreed upon with the VC?

If option pool shares are included in the pre-money fully-diluted outstanding, the price per share will be reduced and more shares will get issued to the VC.  Accordingly, whether or not the option pool gets baked into the pre-money fully-diluted outstanding shares is an issue with real consequences, as it determines whether founders get diluted disproportionately or just pro rata with the VC.  If the shares in the option pool are included in the pre-money fully-diluted shares, the founders get diluted disproportionately by the option pool shares; if the option pool is excluded from the pre-money shares outstanding, both founders and the VC get diluted proportionately.

VCs will almost always include the option pool in the pre-money shares outstanding.  A typical term sheet submitted by a VC will contain a provision on this point as follows:

“The purchase price per share is based upon a fully-diluted pre-money valuation of $[_____] (including an employee pool representing [__]% of the fully diluted post-money capitalization).”

Most entrepreneurs obsess on the portion of the foregoing sentence preceding the parenthetical; they should focus on the parenthetical as well.  Simple illustration: Assume a pre-money valuation of $4 million, one million shares outstanding, a VC investment of $1 million and a 15% option pool.  Now assume the company is sold for $10 million (the liquidation preference impact on valuation will be explored in Part II of this two-part series).  The difference in outcomes is illustrated in the charts below:

Pre-Money Valuation $4,000,000
Founders Shares   1,000,000
VC Investment $1,000,000

Scenario 1:  No Option Pool

Founders Shares 1,000,000   (80% post)
Price per Share $4 ($4,000,000/1,000,000)
VC Shares 250,000 ($1,000,000/$4) (20% post)
Proceeds per Share $8
Proceeds to VC $2,000,000
Proceeds to Founders $8,000,000

Scenario 2:  Option Pool Not Baked into Pre-Money

Founders Shares 1,000,000   (68% post)
Price per Share $4 ($4,000,000/1,000,000)
VC Shares 250,000 ($1,000,000/$4) (17% post)
Option Shares 220,588 (15% x 1,470,588 = 220,588)
Proceeds per Share $6.80
Proceeds to Employees $1,500,000
Proceeds to VC $1,700,000
Proceeds to Founders $6,800,000

Scenario 3:  Option Pool Baked into Pre-Money

Founders Shares 1,000,000 (65%)
Price per Share $3.25 ($4,000,000/1,230,769)
VC Shares 307,692 ($1,000,000/$3.25) (20% post)
Option Shares 230,769 (15% x 1,538,461 = 230,769)
Proceeds per Share $6.50
Proceeds to Employees $1,500,000
Proceeds to VC $2,000,000
Proceeds to Founders $6,500,000

As indicated above, the consequence of the option pool getting baked into the pre-money shares is that the founders get diluted from 80% to 65%.  In absolute dollar terms, the result becomes more dramatic as the proceeds on the sale of the company increase. The VC, however, remains at 20%.

As between the VC and the founders, the VC actually has the better argument here.  The pre-money valuation is predicated on a management team capable of successfully implementing the business plan.  If the founders themselves do not constitute a complete management team, any equity needed to recruit talent should come out of their basket.  The pain to the founders could be mitigated by limiting the option pool to a reasonable level.  As a general rule, the pool should be just enough to cover the grants expected to be made until the next funding round.  The founders should endeavor to present a credible plan showing how many options the company will need to grant to satisfy its recruiting and retention needs up to that next round.

The other way to approach all of this is to treat the pre-money option pool placement as an alternative to lowering the valuation.  In the above example, by putting a 15% post-money option pool in the pre-money calculation, the VC was essentially asserting that the company is effectively valued at $3.25 million, not $4 million.  But the term sheet will not say “the effective pre-money valuation is $3,250,000.”  That’s for the founders to figure out.

My next blog post will explore the other major valuation buster, liquidation preference, which could have an even more dramatic effect on the founders’ bottom line.

 

Your startup was launched only a few months ago and your co-founder has just informed you that he’s leaving.  It hits you that your co-founder just walked out the door with 50% of the equity in the company.  Oops.

Founder breakups are not uncommon, but what happens to the exiting founder’s stock will depend on whether or not the founders had agreed in advance on a vesting arrangement.  Essentially, vesting of stock means that all or a portion of it effectively gets “earned” either over time or upon achieving milestones or a combination of both.  The purpose is to align incentives: encourage founders to remain with the company and avoid the unfairness inherent in walking away with unearned equity.  The arrangement is typically effectuated with the right of the company to repurchase the individual’s unvested shares, usually at some nominal price.

Background

So if the company could be given the right to repurchase unvested shares for a nominal amount, why not just issue the shares at each vesting interval instead of issuing them all at the outset and then repurchasing shares that haven’t vested?  The answer is that issuing shares subject to vesting creates a significant tax planning opportunity for the shareholder.  Shareholders are typically better off being taxed when shares are least valuable, i.e., at or within a short period following formation.  Although shares issued under a vesting schedule are subject to a substantial risk of forfeiture and would therefore generally be taxed as they vest, shareholders can choose to be taxed at the time of issuance, i.e., when the shares are valued low, by filing a simple Section 83(b) election with the IRS.

Another reason for founders to agree to subject their shares to vesting is that VCs will typically insist on it at the time of their investment in order to incentivize founders to stay, and VCs are more likely to agree to preexisting vesting arrangements if they are reasonable.

Vesting arrangements involve several variables, each of which should be considered based upon the unique facts and circumstances of each case.  The three main variables are vesting schedules, repurchase price and acceleration.

Vesting Schedules

 Vesting schedules can be either time based, milestone based or a combination of both.  Careful consideration should be given to immediate vesting of a portion of the shares allocated to a founder to the extent that founder has made any significant pre-issuance contributions to the startup.  Vesting schedules should also be driven by founders’ expectations of their respective efforts going forward.  The most common arrangement is four-year vesting with a one-year cliff, meaning that 25% of the individual’s total share allocation vests after one year, with 1/48th of the total shares vesting every month for the next 36 months.  Of course any significant pre-issuance contribution by a founder might justify vesting a certain percentage right away.  Milestone-based vesting (e.g., some percentage of shares vest upon the development of a prototype) might be appropriate for a founder who is being relied upon to focus on development of the company’s technology.

Repurchase Price

Under any vesting arrangement, the company has the right to repurchase any shares that have not yet vested at the time of termination of employment.  The repurchase price in most vesting arrangements is some nominal amount per share (e.g., $0.0001 per share), which is intended to be the amount paid by the founder, regardless of the nature of departure.  Arguably, upon terminations by the company without “cause” or by the founder for “good reason”, the vesting agreement should provide for repurchase at fair market value at the time of repurchase as determined by the board of directors in good faith or as otherwise determined by the parties.

 Acceleration

Founders usually negotiate for accelerated vesting upon an acquisition or change of control of the company.  Investors resist this on the theory that it would make the company a less attractive acquisition candidate inasmuch as a buyer will want to know that key employees will continue to be incentivized to remain with the company at least through some transition period.  A compromise here would be something called double trigger acceleration: unvested shares would vest automatically if the founder is terminated (typically without cause) within some period of time, usually six months to one year, following a change of control.  Most acceleration provisions call for vesting of 100% of unvested shares upon the triggering event.  A better approach might be to equate the percentage of acceleration with severance.  If the individual is entitled to severance of 50% of base salary upon a termination following a change of control, perhaps the vesting of 50% of unvested shares should be accelerated.